Wrapped Tokens: Enhancing Blockchain and DeFi Integration

Wrapped Bitcoin and wrapped crypto tokens are terms that cryptocurrency enthusiasts may be familiar with. Blockchains such as Ethereum and Bitcoin have separate functionality and protocols, and they cannot communicate with one another because of a fundamental difference in their algorithms. Although this independence protects the security and sovereignty of individual blockchains, it also poses a difficulty in developing an interoperable ecosystem that facilitates the easy flow of data.

For example, wrapped crypto tokens find a legitimate use in decentralized finance (DeFi), where a smooth, quick, and efficient flow of funds is essential. To solve the interoperability in Blockchain problem, some more modern blockchains, such as Polkadot, were developed. Wrapped tokens were developed due to the need to discover a way to facilitate communication across early networks like Bitcoin and Ethereum.

This article aims to answer the following questions: What are wrapped tokens? What can you do with them as an investor or trade?r What is the purpose of wrapped tokens in the cryptocurrency space?

What Are Wrapped Tokens?

If you’re a frequent trader or user of decentralized exchanges (DEXs), you may have encountered several tokens or cryptocurrencies that appear similar but are actually quite different from the cryptocurrency for which they are intended.

For instance, tokens like wBTC, wETH, and even wDOGE may have the prefix “w” attached to them. These are essentially the packaged form of the cryptocurrencies you are familiar with. As a result, wDOGE is really wrapped Dogecoin (DOGE), while wBTC is wrapped Bitcoin (BTC).

Wrapped crypto tokens are digital currencies used on the DeFi platforms and linked to the value of another original cryptocurrency or assets like gold, equities, shares, and real estate. This connection is particularly valuable in real world asset tokenization, where physical assets can be represented on blockchain platforms through wrapped tokens.

A newly minted token is issued to transact on other platforms,, and the old asset is “wrapped” into a digital vault. Wrapped tokens enable the usage of non-native assets on any blockchain, create network bridges, and bring interoperability to the cryptocurrency realm. 

They can stand in for various assets, including real estate, fiat money, equities, commodities, and digital assets. Wrapped tokens require careful consideration and management by a custodial company that will both wrap and unwrap the asset because they are tied to another asset. We’ll look at why this is a constraint in the decentralized space of cryptocurrency.

Wrapped Bitcoin

The first wrapped tokens, known as wrapped Bitcoin or wBTC, were utilized by smart contracts in the Ethereum blockchain to provide investors with a fixed income. In addition to Bitcoin, other assets primarily compliant with Ethereum ERC-20 and Binance Smart Chain BEP-20 are included in the list of wrapped tokens. 

Strange as it may seem, ETH is not compatible with ERC-20 tokens because they were created before them, even though they are issued on the Ethereum network. Ether must, therefore, be wrapped to adhere to other ERC-20 token requirements, much like Bitcoin. This results in the creation of an Ethereum platform tokenized version of ether.

To make DeFi applications more accessible, other blockchains, such as Cardano, Polkadot, and Solana, have begun experimenting with wrapped tokens. These tokens are also paving the way for digital asset tokenization, offering more options for integrating non-native assets into blockchain ecosystems.

The bLuna, a wrapped Luna currency that may be exchanged freely or used as collateral on other protocols on the Terra network—a price-stable and growth-driven platform—is one of the more recent initiatives of warped tokens.

Types of Wrapped Tokens

Despite having a lot in common with the more well-known wrapped coins, it is generally accepted that stablecoins were the first kind of wrapped tokens. For instance, USDT (Tether), a stablecoin, is backed by about one dollar. Tether’s reserves, however, comprise a variety of assets, including cash and cash equivalents, investments, loan receivables, and more. As a result, it does not maintain an exact quantity of actual USD for each USDT owned.

Wrapped tokens come in two varieties: redeemable and cash-settled. Cash-settled tokens cannot be exchanged for the underlying asset. Redeemable tokens, on the other hand, let investors swap the wrapped token for the underlying asset. Wrapped tokens are hosted on other blockchains. For example, wrapped privacy coins are stored on the ZCash or Monero blockchains, which are vital in the asset tokenization development company ecosystem for handling private and secure transactions.

How Wrapped Tokens Work?

To create and destroy wrapped tokens, two procedures are used: “minting” and “burning.” The underlying asset, in this case BTC, is sent to a custodian, who keeps the BTC in a digital vault, in order to issue a wrapped token like WBTC. An equal number of WBTC can be created when the underlying BTC has been secured. 

Another way to think of this process is as “wrapping.” A smart contract is used to “wrap up” the underlying item in a digital vault, and a fresh wrapped asset is created for use on a different blockchain.

On a particular platform, such as Ethereum, the custodian mints, at the request of merchants such as Airswap, CoinList, 0x, AAVE, or Maker, the quantity of the original token sent. 

The user will ask the custodian to release the wrapped token from the reserves in a similar manner if it has to be changed back into the original asset or a coin like Bitcoin. Put another way, for each wBTC that is in circulation, for instance, a Bitcoin is held by a custodian.

The process of creating and maintaining wrapped tokens is a constraint in the cryptocurrency space since it negates the goal of having an open and decentralized blockchain ecosystem by requiring a custodian to be trusted with the assets. 
Because traders cannot use wrapped tokens independently for cross-chain transactions, a custodian is still needed. But since technology is developing so quickly, we may soon have access to some decentralized choices.

The Role of Wrapped Tokens in DeFi

There is a big use case for wrapped tokens in the DeFi (Decentralized Finance) industry. They improve liquidity and capital efficiency on DeFi platforms by allowing a greater variety of assets to engage in the DeFi ecosystem through linking different blockchains. With Ethereum-based DeFi applications, users can utilize assets from blockchains such as Bitcoin and benefit from Ethereum’s lending protocols and smart contracts.

Why Wrapped Tokens Are Important?

Interoperability in blockchain is made possible by wrapped tokens like wBTC, allowing users to transfer assets and utilize features and apps on other blockchains with ease. These benefits could include yield farming potential, reduced fees, and quicker transaction times.

We must recognize that blockchain apps and cryptocurrency systems like Bitcoin and Ethereum are essentially entirely distinct communication networks in order to comprehend wrapped tokens and the motivations for the creation of wrapped cryptocurrency.

Although they share some lines of code that can appear to be extremely similar, their writing styles and coding conventions are very distinct from one another. Consider it as two separate languages: while we might be able to recognize some comparable phrases or even word-for-word translations from another language, the vocabulary and grammatical structures of the two languages are so dissimilar that we are not truly able to speak the other language using the rules of our own language.

To guarantee that any blockchain network may maintain its own independence and dependability, it is essential to recognize its differences and independence. But it also makes it very difficult for people to try to communicate with one other.

While Ethereum and other blockchains have a large number of compatible networks with which they can communicate, the majority of other major crypto networks are limited to conducting transactions through their own channel. The Bitcoin network is limited to communicating to other Bitcoin networks. This also applies to Litecoin and Dogecoin.

Blockchain Interoperability

Blockchain interoperability is the term used to describe the field devoted to resolving this kind of inter-blockchain communication issue. Over the last few years, blockchain interoperability has significantly increased. For instance, moving Bitcoin and Ethereum across other blockchains that aren’t native networks is rather commonplace these days.

People who enjoy trading on decentralized exchanges, or DEXs, where numerous networks connect with one another to buy, sell, or even lend different kinds of digital assets across multiple blockchain networks, will find this to be extremely helpful.

In the absence of the wrapping option, you would need to transfer your Bitcoin to an exchange and deposit it there as collateral in order to borrow ETH with Bitcoin. However, with DEFI, if you wrap your Bitcoin, you effectively keep it and use it to borrow ETH instead of spending it. After transacting, you can always redeem your wrapped bitcoin to get it back on the original blockchain.

In this type of decentralized finance (DEFI), wrapped tokens have emerged as a crucial component that enables users to transfer nearly any kind of asset between blockchains and utilize them throughout a vast cryptocurrency ecosystem composed of numerous types of networks.

One way to address this issue was to create wrapped tokens. You can efficiently transfer assets between blockchains and utilize them throughout the cryptocurrency ecosystem by using wrapped tokens. Bridges, a technology that lets you wrap your own tokens to transfer them between blockchains, are becoming more and more common, even as the quantity of WBTC in circulation has been continuously rising.

This development is not without some risk: Ethereum developer Vitalik Buterin stated in January 2022 that he is “pessimistic about cross-chain applications” due to bridge security weaknesses, having been the target of multiple breaches.

Risks Involved When Using Wrapped Tokens

When determining if wrapped cryptocurrencies are suited for you, there are at least two important hazards to take into account. The first is the security of your wrapped tokens, which is probably more important to most individuals.

Security

There may be disagreements among many over whether blockchain is more secure when it comes to the security of particular blockchain networks.

It seems unlikely that many would doubt the security of Bitcoin or Ethereum, given these are established networks that are getting harder for bad actors to access and control. The kind of algorithm that is protecting them is mostly to blame for this. The Proof of Work algorithm is the foundation for network security used by both Ethereum and Bitcoin until the release of the new version in late 2022.

Presently, Proof of Stake networks are employed across the majority of the DEFI ecosystem, where wrapped tokens are used. These networks may be thought of as less secure and more open to hacker or theft exploitation. Because the Bitcoin network is practically impenetrable to hacking efforts, Bitcoin holders on the actual network believe they are extremely safe from hacks.

However, it has been reported that bridging products and wrapping protocols fail, causing users to lose their wrapped tokens due to attacks. For instance, users lost 120,000 wrapped ETH, or wETH, in February 2022 as a result of a successful exploit of the enormous Wormhole bridge, which at the time was valued at over $320 million.

Co-founder of Ethereum Vitallik Buterin thinks that some of these fundamental security limitations of bridges are unfixable, and he would much rather have a “multi-blockchain” ecosystem than cross-chain apps or blockchain interoperability, which are the main goals of wrapping and bridging.

Centralization

Using wrapped tokens also has the drawback of requiring a higher level of centralization. As previously mentioned, in order to wrap a token, you have to entrust the custodian with your real cryptocurrency asset, who will mint and burn the wrapped tokens. This means that you have to put your trust in the intermediary to wrap things up for you, not in a separate smart contract.

Buterin himself expressed doubts about the legitimacy of these organizations offering to trade your money for their various wrapped versions because he thought that more people using them would lead to unethical behavior related to manipulating and consuming the market.

Therefore, make sure you’re using a mature wrapping product or bridge if you do need to use wrapped tokens or wrap your cryptocurrency. Additionally, unless you have a compelling reason to do so, like adding liquidity to a DEX swapping pool, try not to hold onto your wrapped tokens for an extended period of time.

The sooner wrapped tokens can be burned or redeemed for original tokens, the better. Naturally, security will also likely strengthen as wrapping and bridging technologies advance. As bridging and wrapping become more straightforward, it’s possible that we’ll all be able to transfer assets freely between blockchains in the near future without even realizing that they aren’t connected to one another.

Other Wrapping Protocols or Products

Returning to the topic of blockchain interoperability, a number of blockchain products or protocols are designed expressly to enhance interoperability. Since they effectively build bridges across various blockchain networks to enable users to transfer digital assets between blockchains, these are also referred to as “bridges.”

Optimism, Polygon, and Arbitrum are a few bridges that are becoming more and more common in DEX aggregators and DEFI networks. By avoiding the technical steps involved in wrapping and redeeming, their solutions and bridges aim to make the wrapping process easier for users and enable them to trade or transfer assets directly between multiple blockchains.

Rather than using manual bridging, these bridges generate wrapped tokens and redeem them in the background, sometimes at even lower costs and faster speeds. You might not even come across wrapped tokens when utilizing these, at least not in an obvious way.

Conclusion

With their improved cross-chain compatibility and liquidity, wrapped tokens signal a substantial breakthrough in the cryptocurrency industry. Wrapped tokens provide the easy transfer of digital assets between various blockchain ecosystems by utilizing ERC-20 tokens and other token standards. Tokenization improves asset usage and opens up new possibilities for DeFi apps and cryptocurrency trading.

As blockchain technology develops further, wrapped tokens will play an increasingly important role. Understanding and leveraging wrapped tokens can provide you a competitive edge whether you’re working on specialized DeFi platforms, cryptocurrency exchanges, or smart contract development. In the end, wrapped tokens provide new possibilities for a digital asset ecosystem that is more flexible and interconnected.

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